Mergers & Acquisitions: Crushing It as a Corporate Buyer in the Middle Market

By Kevin Tomossonie

Practical, real-world advice and technical knowledge for corporate buyers who do M&A

 

Did you ever do a search for the failure rate of M&A deals? Apparently, it's high. In fact, there are many studies that say M&A deals tend to fail a majority of the time, especially for corporate buyers. But are these statistics really true? Because if the majority of deals fail, then why would anyone keep doing them year after year? Does anyone do them right?

 

Actually, a lot of people do them right. But if you believe the statistics, there seem to be a lot more people doing them wrong. The question is, how can buyers do deals the right way, so that they don't become just another statistic? This book answers that question and explains exactly how corporate buyers in particular can do deals the right way.

 

Buyers who have the right mindset to approaching their deals, and a process that involves the right people with the right skills, are much more likely to have success in M&A. With that being said, this book contains practical real-world advice that has been applied in actual deals, and it provides the framework, best practices, and technical skills that are so important for executing successful deals and avoiding the failures.

 

What's inside

 

Part one of the book provides a basic overview of the M&A market. It then turns its attention to the corporate buyer and explains some of the more common reasons why deals tend to fail for corporate buyers. From there, it provides a framework for these buyers to develop their own playbooks for approaching and executing deals in a consistent, reliable, and repeatable way.

 

Part two of the book begins to cover some of the more technical details that a buyer should know when doing a deal. It explains in detail how M&A deals are structured and negotiated. It also points out where buyers need to be careful as they negotiate, so that they're choosing the right structures, keeping the economics of a deal fair, and aren't taking on any unnecessary risks.

 

Part three of the book explains how businesses are valued, with a focus on the middle market where many businesses are privately owned. It explains purchase price multiples, discounted cash flow analysis, and how to measure returns. It also explains how accretion and dilution are created from a deal and why that's so important to a corporate buyer. Then, the book provides a framework so that buyers can use all of this information together in order to objectively decide for themselves what a business should be worth when negotiating a deal.

 

Part four of the book covers some of the more advanced topics that buyers should be aware of when doing deals so that they don't run into unexpected surprises after a deal has closed. This includes explaining what a quality of earnings is, why it's important, and how it can affect a buyer's view on the valuation of a business, as well as how to navigate the complexities of carve-outs, cross-border transactions, structuring earn-outs, and valuing intangible assets.

 

From having an appreciation for the mindset and process that goes into executing deals, to understanding how they're structured, negotiated, and valued, this book is intended to be the most useful, practical, and hands-on guide ever written for corporate buyers doing M&A deals in the middle market.

 

• Language: English
• Publisher: Rock Center Financial Partners, LLC
• Release date: May 24, 2020
• ISBN: 9781735052229

Kevin Tomossonie

Kevin Tomossonie is a co-founder and partner at Rock Center Financial Partners, a boutique management consulting and accounting services firm located in New York. He has spent the majority of his career specializing in M&A and has been involved in well over 150 transactions domestically and internationally as both an executive and a consultant. He holds an MBA from the University of Southern California and is a licensed CPA in New York State. To learn more, please visit rockcenterfinancial.com

Book preview

Introduction

This book is intended to be an educational guide for executives, consultants, advisors, students, or anyone else that’s either responsible for, involved in, or interested in learning more about mergers and acquisitions (or M&A).

As you can probably tell from the title, this book was mostly written with corporate buyers in mind. Why? Because there seem to be a lot of studies out there that say corporate buyers don’t have a good success rate when it comes to doing M&A deals. If you don’t believe it, do an online search for ‘M&A failure rates’ and you’ll see the statistics for yourself. There are many studies that say corporate M&A deals fail to achieve their expected results, fail to create value, or that they even destroy value a majority of the time. But why is this? And even more importantly, how can corporate buyers avoid from being one of these statistics?

With this being said, the main purpose of this book is to educate corporate buyers. In fact, it’s been written specifically for U.S. corporate buyers that do deals both domestically and internationally. In it, we explain how these buyers can have the strategic mindset, best practices, and technical skills that are so important for achieving success in M&A. The truth is that there’s no one thing to getting an M&A deal right. No one person that does it all, and no magic formula. There’s a mindset and a process to it. Corporate buyers that have the right mindset to approaching their deals, and a good process that involves the right people with the right skills, are much more likely to have success in M&A.

While M&A can be a very complicated topic, this book tries to keep things as clear and as straight forward as possible. The intent is so that readers from different backgrounds, with different skillsets, and different levels of experience can all benefit from it. It contains practical, real-world knowledge that has been applied in actual deals. And while some of the concepts do become quite advanced at times, the book tries to build each reader’s base of knowledge from the ground-up, so that whether you’re a novice or an experienced practitioner, this book can help you better understand some of the most important M&A concepts, and how to apply them.

Part one of the book begins with a basic overview of the M&A market. It explains who the buyers are, who the sellers are, and what motivates each of them when doing a deal. It then turns its attention to the corporate buyer. It explains some of the more common reasons why deals tend to fail for corporate buyers and how to avoid from making those mistakes. It goes into detail on how corporate buyers can develop their own playbooks for approaching and executing deals in a consistent, reliable, and repeatable way.

Part two of the book begins to cover some of the more technical details that a buyer should know when doing a deal. It takes a deep dive into how M&A deals are structured and negotiated. It explains some of the most commonly used deal structures and terms. Describing what they are, what they do, and the mechanics of how they work. It also points out where buyers in particular need to be careful as they negotiate deals so that they’re choosing the right structures, keeping the economics of a deal fair, and aren’t taking on any unnecessary risks. This part of the book does begin to get somewhat technical at times. And while it’s not necessary, it is helpful if readers have an understanding of what the basic financial statements of a business are, like an income statement and a balance sheet. This way, as these technical concepts are discussed, they can be more fully appreciated.

Part three of the book explains how businesses are valued with a focus on the middle market where many of the businesses that are bought and sold each year are privately owned. It explains in detail some of the most common methods that buyers use to value the businesses they buy, including purchase price multiples, discounted cash flow analysis, and how to measure returns. It also explains how accretion and dilution are created from a deal and why that’s so important to a corporate buyer. After the different valuation methods and concepts are explained, the book provides a framework so that buyers can use all of this information together in order to objectively decide for themselves what a business should be worth when negotiating a deal.

While part three of the book does cover some very technical topics, it tries to keep the conversation at a practical level. So that again, readers from different backgrounds with different levels of experience can all appreciate the concepts that are explained and the types of questions that should be asked when making valuation decisions. This is done by focusing the text of the book on the concepts and pushing the detailed calculations behind those concepts into the appendix of the book. This way, readers who are less interested in seeing the detailed calculations can focus on what’s discussed, and readers who are more interested in seeing the calculations and applying them in their own deals, can go to the appendix to see exactly how they’re done. Readers can also visit www.rockcenter.us for free downloadable word and excel versions of this book’s appendix.

Part four of the book covers some of the more advanced topics that buyers should be aware of when doing deals, so that they don’t run into unexpected surprises after a deal has closed. This includes explaining what a quality of earnings is, why it’s important, and how it can affect a buyer’s view on the future projections and valuation of a business. It also discusses how to navigate the complexities of carve-out and cross-border transactions. Earn-outs and intangible asset valuations are also discussed in part four of the book.

From having an appreciation for the mindset and process that goes into executing deals, to understanding how they’re structured, negotiated, and valued, this book is intended to be the most useful, practical, and hands-on guide ever written for corporate buyers doing M&A deals in the middle market. We hope that you enjoy it.

Part One:

Building an M&A Playbook

‘If you’re thinking of buying a business, any business, you’re not going to do it alone. There’s too much to do, too much to look at, too many questions to ask.

You’re going to need a team.’

Chapter 1: Defining the Middle Market

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Mergers & acquisitions (or M&A) is a term that refers to the act of buying and selling businesses. It provides sellers with liquidity (meaning access to cash when they want to sell), and it provides buyers with opportunities to either expand their own existing businesses or invest for financial purposes. It’s a global activity that happens between buyers and sellers every day both domestically and internationally.

Sometimes, you’ll hear about the largest of M&A deals in the news. The amounts can be enormous with values in the tens of billions of dollars. And when the companies are well known, it can give analysts and reporters plenty to talk about. But for all of the press and publicity that the big deals get, they only represent a small percentage of the actual number of deals that take place every year.

To put it in perspective, in a typical year there are somewhere around 13,000 M&A transactions announced in the U.S. alone. But out of all these deals, only around 300 to 400 of them (or around two to three percent of them), are valued at over $1 billion. In fact, the majority of deals that take place every year fall well below that amount, in a space known as the middle market.

Deal Sizes

It probably goes without saying, but the sizes of businesses that are bought and sold each year can range from very small to very large. When a small business is in play, it can be fairly easy for a buyer to evaluate it and negotiate a deal to buy it. But as a business gets bigger, it can become much more difficult for a buyer to evaluate. And negotiating a deal to buy it, can become much more complicated. Bigger businesses also tend to command higher prices. Harder to evaluate, more complicated to negotiate, and higher prices, tend to mean more risk for buyers as the size of a deal increases.

The M&A market is more or less segmented along these lines and defined based on the sizes of businesses that are bought and sold. These segments are basically referred to as small deals, middle market deals, and large deals.

Small deals are usually thought of as involving businesses with less than $10 million a year in revenue. Startups fall into this category, but for the most part, when it comes to M&A, these are usually thought of as your main street types of businesses like convenience stores, delis, hairdressers, and other local establishments.

Middle market deals are the next level up. These are usually thought of as involving businesses from as low as $10 million a year in revenue, all the way up to $1 billion a year in revenue. It’s a very wide range of values that includes businesses of all different types. Manufacturers, distributors, service providers, technology companies, you name it. And as you can imagine, because of the wide range of values that are involved, businesses at the lower end of the middle market will often look very different than businesses at the higher end of the middle market. Which is why many professionals who work in the space tend to use the terms lower-middle market when referring to businesses below $50 million and upper-middle market when referring to businesses above $500 million.

At the highest ends of the M&A market are the large and mega deals. The large deals are usually thought of as involving businesses from $1 billion to $10 billion a year in revenue and the mega deals are those that have revenues over $10 billion.

Too Small, Not Interested

When it comes to the small deals, which for the most part are thought of as being the main street types of businesses, these are often not seen as being scalable, or in other words growable enough, so that an investor would be interested. You see, investors want returns on their investments, and their returns need to be big enough that it makes the risk of investing worthwhile. If they don’t see a business as something that has ‘legs’ which can grow, or something that they’ll be able to pull their money out of when they want to at some point, then they won’t want to invest. While these types of businesses are still bought and sold each year, they’re usually done between individuals (like moms and pops) for personal reasons. For example, when a seller wants to retire, and a buyer is looking for a source of income. While it can be, it’s usually not something that a corporate or financial buyer would be interested in.

Too Big, Too Expensive

When it comes to the large deals, and the mega deals, north of $1 billion, it’s really only the big players with a lot of capital that can afford to do these. And with the big deals, there are no guarantees. Things can still go wrong. So, with a lot of money at play, and the risk that things can still go wrong, the big deals are not for everyone. They’re for buyers with deep pockets who can afford to fix things if they have problems. In fact, when it comes to acquisitions in general, most buyers don’t want to bite off more than they can chew. They’ll have a range of deal sizes that they’re willing to play in based on how much capital they have to invest and the amount of risk they’re willing to take on.

The Middle Market, A Sweet Spot for M&A

If small deals aren’t really that interesting, and large deals are too expensive, then where do buyers look? For buyers with money to invest that are looking for businesses with good growth opportunities and at reasonable valuations, the middle market just might be the place. It’s a big space that includes businesses from as small as $10 million a year in revenue all the way up to $1 billion, and it represents about one-third of the U.S. economy. In it, there’s a wide range of opportunities, which is why it’s been a long-time sweet spot for many investors.

A few examples of the types of businesses that you’ll find at the lower end of the middle market include small businesses that are competing in fragmented industries, which can sometimes provide opportunities for investors that are looking to consolidate. Or, relatively young businesses with proven concepts that are experiencing growth and can provide opportunities for investors looking to participate in that growth. Or, niche products and services that can make nice add-on acquisitions to existing (more established) business.

As you work your way up the food chain from the lower-end of the middle market to the upper-end of the middle market, the businesses obviously get bigger. As they do, it’s not uncommon to find businesses that are so well established that they’re considered leaders in their spaces. Either geographically, or in terms of the products and services they provide. Acquisitions like these will usually bring with them a nice stream of earnings and can either provide an instant leadership position in a space or act as a platform for future acquisitions. These are just a few examples of what you’ll find in the middle market, which is why it’s considered such a sweet spot for investors.

Buyers and Why They Buy

In the middle market, there are basically two types of buyers. Strategic buyers and financial buyers. Both are likely to follow a similar process when they do deals, but they’ll usually have different reasons for wanting to buy a target business, and different ideas for how long they plan on staying in that business. And by the way, the term ‘target’ refers to a target business that’s about to be acquired.

A strategic buyer (which is also referred to as a corporate buyer), is usually, although not always, a company that’s already operating in the same industry as the target. Usually, corporate buyers will want to acquire targets for strategic purposes. It could be that the target is a competitor that the buyer wants to take out of the picture. It could be a supplier or a customer that the buyer doesn’t want someone else to acquire. It could be for geographical expansion, access to new products, or to diversify its portfolio. Whatever the reason, a corporate buyer is usually already operating in the same space as a target, where it already has an experienced management team, and it’s interested in owning and operating that target for a long time, which could be forever.

A financial buyer on the other hand (which is sometimes referred to as a financial sponsor), is an investor or a group of investors that acquire businesses, hold them for some period of time, and then eventually sell (or exit) them with the goal of generating a financial return on their investment. A financial buyer could be a wealthy individual, but in the middle market it’s usually a private equity group.

Private equity groups raise capital from wealthy individuals and institutions for the purpose of investing that capital and providing returns to its investors. This means that private equity groups won’t hold investments forever. Instead, a private equity group will usually have a target hold time (anywhere from 3-5 years), and they’ll only hold their position until it’s a good time to exit, either through a sale of the company, or sometimes through an initial public offering (called an IPO).

Usually, while a private equity group owns a business, they’ll make improvements to it and do some add-on acquisitions in order to grow it and try to make it more attractive to another buyer for when they’re ready to exit. The typical private equity play is to buy a business at a good price, try to grow it and improve it while they own it, and then sell it for a profit.

Sellers and Why They Sell

There can be many different reasons why the owner (or owners) of a business are interested in selling. For example, it could be a small business where the owner wants to retire. It could be a growing business where the owner wants help from a professional management team and access to capital. It could be a private equity owned business where the private equity group wants to exit. Or, it could be a corporate owned business where the corporate owners want to sell and reinvest that money somewhere else.

Whoever the seller is, and whatever the seller’s reasons are for selling, it’s usually financially driven in some way. After all, why else would anyone sell? From a buyer’s perspective, it’s important to know a seller’s motivations. On the extreme end of things, the reason a seller wants out, could be a reason to not buy the business. It could be that the business is in trouble and that the seller wants to get out while they can. But on the other hand, a seller may have a completely legitimate reason for selling and it’s just a good opportunity for the right buyer.

Sometimes, a seller will have other objectives in mind when doing a deal. Not just financial. In a competitive process, meaning where there are several potential buyers that are competing to buy a business, the buyer that can best help the seller achieve those objectives could have an advantage over the other buyers in that process.

For example, let’s say that an entrepreneur was looking to sell a piece of her fast-growing business. She wants a good price, but at the same time, it’s a growing business and she doesn’t want to exit completely. She wants to stay in, continue to run it, and keep a nice piece of equity so she can continue to benefit from its future growth. She wants a partner that will not only pay a good price for a part of the business today but will also be a good partner to work with and help grow the business.

In a situation like this, price is not the only deciding factor for the seller. Which is why, understanding the motivations and intentions of a seller is important in a deal. Not only so that the buyer and seller can structure a deal that works for both sides, but also to make sure that there is a successful transition and operation of the business going forward. We’ll expand more on this later in the book.

Chapter 2: Why Deals Fail and What to Do About It

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Did you ever do an online search for the failure rate of M&A deals? Apparently, it’s pretty high, like somewhere around 70% high, depending on the studies you read. In fact, there are many studies that say acquisitions fail to achieve their expected results, fail to create value, or that they even destroy value a majority of the time. But is this really true? Are the biggest failures of all time skewing the statistics? Are these studies actually capturing the reality of what’s happening in M&A? Because if the majority of deals fail, then why would anyone keep doing them?

A skeptic might take the view that many of the studies out there are misleading. That they’re mostly based on deals between public companies where one publicly traded company acquired or merged with another. You see, with deals like these, there’s usually a lot of publicly available information. Information that lets academics and analysts see exactly what two businesses looked like before a deal and then critique and comment on what happened after the deal. The problem with any study that would only use public deals though, is that it would fail to capture the success rate of private deals, when buyers acquire privately held businesses. In a private deal, there’s hardly ever much publicly available information on a target before a deal happens, let alone how successful it was after the deal. But setting this aside for a minute, let’s say that we accept the statistics, and the premise, that most deals fail.

If most deals fail, then how can it be that private equity groups are able to generate returns for their investors, and why would so many corporate buyers keep doing deals year after year? Someone out there must be doing it right, no? Well guess what, there’s actually a lot of people doing it right. But if you believe the statistics, there seem to be a lot more people doing it wrong. The question is, what can we learn from those who do it right so that we don’t become another statistic?

The number one goal of this book is to explain exactly that. How to do deals the right way. You see, there’s no one thing to getting a deal right. No one person that does it all, and no magic formula. There’s a mindset and a process to doing deals. Corporate buyers that have the right mindset to approaching their deals and a good process for doing their deals will stand a much better chance of having successful deals and avoiding the failures.

And by the way, this doesn’t just mean doing the actual deal itself. Sure, that’s important. But you also need to be able to transition and operate a business after it’s been acquired, so that it can be a success. In order to demonstrate how important this point is, next, we’ll use a hypothetical situation to illustrate what can and sometimes does go wrong when acquisitions aren’t done right. Then, throughout the rest of this book, we’ll provide the framework, best practices, and technical skills that are so important for doing deals the right way.

What Could Possibly Go Wrong?

You’ve probably heard the story before. The story of a large publicly traded company that acquired another. The buyer wanted to do something transformational and paid a high price to acquire a target. The price was supposedly justified on the basis that together the two companies would have synergies. Synergies that would otherwise not exist. Revenues would increase, thanks to the ability to now bundle and cross-sell each other’s products, and costs would go down, thanks to the ability to eliminate redundant costs and consolidate operations. A win-win. Skeptical? Why would you be?

The synergies were carefully crafted by very smart, highly paid consultants. Those consultants analyzed the two businesses in great detail. They looked at market data, compared benchmarks, and calculated all sorts of ratios and metrics. They were convinced that those synergies could all be achieved. And the high price? The buyer had an investment banker advising him and helping negotiate the deal. The buyer was told very convincingly by his advisor that the value of those synergies more than justified the price that was being paid.

The deal was top-secret. It was negotiated behind closed doors. Only the highest-level executives and advisors from the buyer and seller’s teams were involved. Why was it kept to such a small group? Because, neither the buyer nor the seller wanted a leak before they knew for sure that they had a deal. The consequences could have been disastrous if word got out. Or so they thought.

The business teams that would ultimately be responsible for managing the transition, integrating the two businesses, and realizing the synergies? It turns out, they weren’t involved in the deal. Why? Because, they weren’t deal people and nobody thought they needed to be involved. The executives that were involved weren’t worried though. Because they were convinced, that once their business teams knew about the deal, they would be excited for the opportunities. Those executives had no doubt that their business teams would be able to execute on the plans that their consultants had so carefully thought out. More than that, the consultants gave the buyer’s CEO a great idea. Tie the business teams’ bonuses to achieving the synergies. That would motivate them, wouldn’t it? What could possibly go wrong?

On the day that the deal was announced, the buyer’s stockholders immediately became concerned that the buyer was overpaying. They didn’t like the amount of debt the buyer was taking on to finance the deal, and the synergies sounded aggressive. The buyer’s stock price dropped 3% on the very day it was announced. When the deal was communicated to the business teams at both companies, it was received with mixed emotions. Some people were excited, but it seemed like a lot more people were concerned about their futures. The word synergies to them sounded like job cuts.

Some of the more senior business team leaders who would now be responsible for operating the combined businesses and realizing the synergies, they felt a little uneasy about not being ‘in the know’ sooner. And there was concern, deep concern, that those synergies were not realistic or achievable. Why weren’t they consulted sooner? Didn’t anyone at the top value their opinions? Maybe those business team leaders weren’t as valuable as they thought? There was also some resentment that their bonuses would now be tied to achieving the synergies that they didn’t think were achievable.

In the months that followed, the buyer found it harder than they thought to sell their vision for the newly combined businesses. There was turnover of some pretty important people at the target who said that they didn’t like the new culture and were already frustrated with all the new rules they had to follow to get things done. They left for other opportunities.

As time went on, the revenue synergies that were so carefully thought out by those consultants, they never really happened. It turned out that bundling and cross-selling each other’s products didn’t really have an impact on the top-line because there was already a lot of existing customer overlap at the two companies, and those same customers were already buying products from both businesses. Now they’d just be buying their products from the same business. Guess nobody looked at that when the synergies were developed. And when the buyer’s biggest competitor heard the news of the merger, they aggressively cut their own prices in order to remain competitive in the market. Some customers actually left to go to the competition, which hurt the buyer’s sales.

Some of the more achievable cost cutting synergies, those were still pushed down. Mostly headcount reductions though. Duplicate job roles that were eliminated. Those took a toll on employee morale and it seemed like people were less productive after the cuts than they were before. And in the process, the buyer actually realized that not all of the expected cuts were achievable without also disrupting some of the operations at the two businesses. In fact, after combining the two operations, they realized that there were actually some additional costs that weren’t planned for.

After a while, frustrated with the fact that it couldn’t realize the synergies it promised, the buyer ultimately conceded and had to take a write-down on the acquisition. They recorded a big loss and the stock price dropped again on the news.

Does any of this sound familiar? Because, while this was just a hypothetical situation that we used to illustrate what can go wrong, the pattern of events and consequences are very real. The buyer overpaid, overcommitted, and ultimately couldn’t execute on why they thought the deal made sense in the first place.

Maybe they misread the market? Fell in love with the deal too early? Were overconfident? Didn’t do enough due diligence? Didn’t involve the right people in the process? Or, maybe they underestimated the execution risks and relied a little too much on their outside consultants? Whatever the reason, this one was a fail. The question is, could any of it have been avoided?

Why Deals Fail

The basic question for whether or not an M&A deal should be considered a success or a failure, is the ability to say whether or not it produced its intended results. If it did, it was probably a success. If it did not, then it’s likely that one or more of the following three things happened. One, the buyer overpaid. Two, the buyer over committed. Or three, there was poor execution.

You may be noticing that we’re not directly calling out strategy right now. And while it absolutely is the case that a bad strategy, or no strategy at all, can lead to an M&A failure, in this book, we won’t be telling buyers how they should be setting their own strategies. Instead, that should be up to each buyer to decide for themselves. But what we will do in this book, is explain how buyers can use M&A as a tool to support their strategies, and how to negotiate good deals.

With this being said, let’s put strategy aside for a minute to explain how buyers can avoid some of the more common M&A failures, at least from an execution standpoint. And then, in the